Actuarial valuation of temperature derivatives

Abstract

Weather affects our daily lives as well as choices. We define the term weather derivative. It is a new class of investment that is yet to gain ground in Africa since the underlying security (weather) is not a trade able asset. In our study we look at 6 different pricing methods for temperature based derivatives. We settle on the one proposed by Alaton and incorporate one of his suggestions, that is, allowing for temperature volatility to be a stochastic process rather than some piecewise constant function. Finally, we use the actuarial method of valuation and find out that the option price greatly depends on our value of the strike price. We conclude that allowing for the mean reverting parameter to also be a stochastic function will greatly improve our option pnce.